2009-08-28

With the current housing recession in North America, investors are scared. Even bargain hunters are scared, since there's no telling whether or not the market has found its bottom.

But a savvy investor needs not seek the bottom to find good value. After all, what matters is the absolute return on investment, which can come from the capital gains from the sale or the continuous cash flow from renting.

Here is one of the most popular recipes for real estate investment:

Buy a property with as little down as possible

Optionally make improvements to it, to increase its resale appeal

Wait for price appreciation

Sell it and collect the gains.

What's the problem with this? The main problem -- and this is where speculators and unsophisticated investors got hurt the most in this downturn -- is that this relies heavily on the direction of the market -- a market which doesn't necessarily abide by sound principles, but that fluctuates based on sentiment.

By now everyone knows that the real estate market doesn't always go up. On top of that, adding leverage (the debt from the "little down" part), magnifies the effects of possible losses if the market doesn't cooperate.

This recipe worked for a while, but no more.

Is there a sound alternative?

Absolutely. How about this for a new framework:

Lower your entry price

Choose a stable to growing market

Sell it for a profit or collect rent on the lower entry price.

Sounds similar, but the difference is on insisting on an absolute return based on fundamentals, not market sentiment. Let's take this in parts.

Lower the entry price. This can be accomplished by either building from scratch and thus controlling the costs ahead of time or by buying deep fixer-uppers and re-doing them, having a detailed budget beforehand.Choose a stable to growing market. This requires on-going work monitoring the fundamentals of the market in various parts of the world, or trustworthy direct contact with those who do. The real estate market is very local and opportunities may exist in remote places (other countries) or unique circumstances (special construction, unusual locations, islands).Sell it or rent it. Selling for a quick profit may not yield the best return on investment. If you do your homework and plan for buying or building something that can reasonably be expected to yield an absolute return on investment by renting, then selling becomes an option, not a necessity.

An investor close to me recently asked me about buying an apartment where the rent yield was around 5% after deducting most expenses. On an absolute basis though, this is not an impressive return. An investor ought to do better. And hoping for price appreciation to boost the return doesn't qualify under my definition of a safe investment. So I recommended a pass.

In my next post, I will describe how I'm following this alternate plan: building instead of buying ready-made, focusing on a foreign country with a growing market, and planning for the investment to make sense based on renting rather then relying on the whims of the market to bail me out. Stay tuned.